As a result of a recent review of members that sell structured
products, NASD staff is concerned that members may not be
fulfilling their sales practice obligations when selling these
instruments, especially to retail customers. This Notice to Members
provides guidance to members concerning their obligations
when selling structured products, including the requirements to:
(1) provide balanced disclosure in promotional efforts; (2) ascertain
accounts eligible to purchase structured products; (3) deal fairly
with customers with regard to derivative products; (4) perform a
reasonable-basis suitability determination; (5) perform a customer-specific
suitability determination; (6) supervise and maintain a
supervisory control system; and (7) train associated persons.

Questions/Further Information

Questions regarding this Notice may be directed to Gary L. Goldsholle,
Associate Vice President and Associate General Counsel, Office of
General Counsel, Regulatory Policy and Oversight, at (202) 728-8104.

Background

Structured products are securities derived from or based on a single
security, a basket of securities, an index, a commodity, a debt
issuance and/or a foreign currency.1 As the foregoing definition
suggests, there are myriad types of structured products. Some
structured products offer full protection of the principal invested,
whereas others offer limited or no protection of the principal.

Most structured products pay an interest or coupon rate substantially above the
prevailing market rate.2 Structured products also frequently cap or limit the upside
participation in the reference asset, particularly if some principal protection is offered
or if the security pays an above-market rate of interest.

Structured products, which are typically issued by investment banks or their affiliates,
have a fixed maturity. Some, but not all, structured products may be listed on a
national securities exchange. Moreover, even those structured products listed on a
national securities exchange may be very thinly traded.

Structured products typically have two components—a note and a derivative (often
an option). The note pays interest to the investor at a specified rate and interval.
The derivative component establishes the payment at maturity. In some products, the
derivative is, in effect, a put option sold by the investor that gives the issuer the right,
but not the obligation, to sell the investor the reference security or securities at a
predetermined price. In other products, the derivative is, in effect, a call option sold
by the investor that gives the issuer the right, but not the obligation, to buy from
the investor the reference security or securities at a predetermined price. Despite the
derivative component of a structured product, they are often marketed to investors
as debt securities.

Sales of structured products began in the 1980s. The products gained popularity with
institutional investors in the 1990s. More recently, members have reported to NASD
that structured products have been increasingly targeted at retail investors. Many of
the structured products targeted at retail investors are based upon "blue-chip" and
"household-name" stocks that comprise the S&P 500 or the NASDAQ-100 indexes. NASD
staff has concerns about the manner in which structured products may be marketed to
retail investors and the types of investors purchasing such products. As such, NASD is
issuing this guidance to members addressing sales practice issues.

Regulatory Requirements

The application of NASD rules to activities involving structured products, including
Rules 2110 (Standards of Commercial Honor and Principles of Trade), 2210
(Communications with the Public), 2310 (Recommendations to Customers), 2720
(Distribution of Securities of Members and Affiliates—Conflicts of Interest), 3010
(Supervision), and 3012 (Supervisory Control Systems), is discussed below.

1. Promotion of Structured Products

Offerings of structured products generally are conducted as public offerings of
securities registered under the Securities Act of 1933. In most cases, structured products
are offered from a shelf registration. An investor purchasing a structured product as
part of a shelf distribution will, prior to purchase, receive a preliminary prospectus
supplement that describes the characteristics and risks of the structured product being
offered. To varying degrees, members also use supplemental sales materials. NASD staff
has observed that the disclosures provided in supplemental sales materials tend to be
less balanced and offer fewer risk disclosures than are contained in the preliminary and
final prospectus supplements.

NASD reminds members that pursuant to Rule 2210, all sales materials and oral
presentations regarding structured products must present a fair and balanced picture
regarding both the risks and benefits. For example, marketing materials should not
portray structured products as "conservative" or a source of "predictable current
income" unless such statements are accurate, fair, and balanced. In addition, Rule 2210
prohibits exaggerated statements and the omission of any material fact or qualification
that would cause a communication to be misleading. Moreover, in promoting the
advantages of structured products, such as the interest rate offered and the
creditworthiness of the issuer, it is necessary that members balance their promotional
materials with disclosures concerning the attendant risks, which may include loss of
principal and the possibility that at expiration the investor will own the reference asset
at a depressed price. In general, NASD staff believes that sales materials and oral
presentations that omit a description of the derivative component of the product and
instead present such products as ordinary debt securities would violate Rule 2210. In
addition, members should be careful to balance any statements concerning the fact
that a structured product has a ticker symbol or has been approved for listing on an
exchange with the risks that an active and liquid trading market may not develop.
Members are further reminded that providing risk disclosure in a prospectus
supplement does not cure otherwise deficient disclosure in sales material, even if such
sales material is accompanied or preceded by the prospectus supplement.3

In some cases, structured products are assigned a credit rating by a nationally
recognized statistical rating organization. To the extent that such credit rating pertains
to the creditworthiness of the issuer (i.e., the ability of the issuer to meet its obligations
under the terms of the structured product) and is not indicative of the market risk
associated with the structured product or the reference security, members must be
careful to delineate these distinctions. Presentation of a credit rating for a structured
product that suggests that the rating pertains to the safety of the principal invested or
the likely investment returns will be viewed as misleading. Members presenting a credit
rating must address the fact that the creditworthiness of the issuer does not affect or
enhance the likely performance of the investment other than the ability of the issuer to
meet its obligations.

2. Eligible Accounts

A. Approved Accounts

Member firms also should consider whether purchases of some or all structured
products should be limited to investors that have accounts that have been approved
for options trading. Given the similar risk profile of many structured products and
options, particularly those where principal invested is at risk from market movements
in the reference security, it may be an appropriate investor safeguard to require that
such structured products only be purchased in accounts approved for options trading.
Firms that determine not to limit purchases of structured products in which investors'
principal is at risk from market movements in the reference security to accounts
approved for options trading should develop other comparable procedures designed
to ensure that structured products are only sold to persons for whom the risk of such
products is appropriate. These firms should be prepared to demonstrate the basis for
allowing investors with accounts not approved for trading options to purchase
structured products.

Members also are reminded that approving an account to trade structured products
is not a substitute for a thorough suitability analysis. Not every structured product will
be suitable for every account approved to trade structured products. A discussion of
suitability is provided below.

B. Discretionary Accounts

Sales of structured products issued by a member, or an affiliate of a member, to
discretionary accounts must comply with Rule 2720 (Distribution of Securities of
Members and Affiliates—Conflicts of Interest). Specifically, paragraph (l) (Discretionary
Accounts) provides that "a transaction in securities issued by a member or an affiliate
of a member, or by a company with which a member has a conflict of interest shall not
be executed by any member in a discretionary account without prior specific written
approval of the customer." Members should review their written supervisory procedures
and practices to ensure that they request and obtain the necessary written approval
of the customer before purchasing structured products in a discretionary account.

3. Suitability and Fair Dealing with Customers

A. Fair Dealing with Customers with Regard to Derivative Products
or New Financial Products

IM-2310-2(e) (Fair Dealing with Customers with Regard to Derivative Products or New
Financial Products) emphasizes members' obligations to deal fairly with customers when
making recommendations or accepting orders for new financial products. The IM states
that "[a]s new products are introduced from time to time, it is important that members
make every effort to familiarize themselves with each customer's financial situation,
trading experience, and ability to meet the risks involved with such products and to
make every effort to make customers aware of the pertinent information regarding
the products."

For certain enumerated products, including a type of structured product listed on
NASDAQ known as "Selected Equity-Linked Debt Securities" (SEEDS), IM-2310-2(e)
provides specific guidelines that members must follow for "qualifying accounts to
trade the products and for supervising the accounts. "In this regard, Rule 4420(g)(5)
requires prior to the commencement of trading of particular SEEDS, delivery to a
broker-dealer of a circular providing guidance regarding its compliance responsibilities
(including suitability recommendations and account approval) when handling
transactions in SEEDS.4 Similar disclosure requirements exist with respect to the listing
standards of structured products on national securities exchanges.5

B. Reasonable Basis Suitability

As noted in Notices to Members (NTMs) 03-07 and 03-71, a member has an obligation
to perform a reasonable basis suitability determination before recommending a
product to investors. A reasonable basis suitability determination is necessary to
ensure that a security—in this case a structured product—is suitable for some investors
(as opposed to the customer-specific suitability determination, which is made on an
investor-by-investor basis). To discharge its reasonable basis suitability obligation, a
member must perform appropriate due diligence to ensure that it understands the
nature of the product, as well as the potential risks and rewards. Members also are
reminded of the guidance issued in NTM05-26, which provides best practices for
developing and vetting new products, including structured products.

Members should consider whether an investment in a structured product meets the
reasonable basis suitability standard if the instrument is priced such that the potential
yield is not an appropriate rate of return in relation to the volatility of the reference
asset based upon comparable or similar investments, in terms of structure, volatility,
and risk in the market as determined at the time the structured product is issued.
For example, similar structured products based on reference securities that possess
substantially similar volatility characteristics, but which offer materially different rates
of return in the note component, should call into question whether the instrument
with the lower yield meets the reasonable basis suitability standard. While an exact
risk/reward calibration among different instruments or investments may not be
possible, NASD expects members to exercise their market expertise to recognize those
situations where the materiality of difference is not in doubt and, consequently,
identify that the lower yielding instrument does not represent a reasonable rate of
return given the attendant risks as compared to other similarly composed products or
direct investments in the underlying components of such products with similar
risk/reward attributes.

C. Customer Specific Suitability

A member also must determine that its recommendation to purchase a structured
product is suitable for that particular investor. Under Rule 2310, members must
ensure that a recommendation is suitable for a specific customer by examining
(1) the customer's financial status, (2) the customer's tax status, (3) the customer's
investment objectives, and (4) such other information used or considered to be
reasonable by such member or registered representative in making recommendations
to the customer.

The derivative component of structured products and the potential loss of the principal
for many such products may make them unsuitable for investors seeking alternatives to
debt securities. While structured products pay interest like debt securities, they often
exhibit very different profit and loss potential. The profit and loss potential of many
structured products is more akin to an option contract, particularly those where
principal invested is at risk from market movements in the reference security. For
such products, it may be useful for registered representatives to consider whether the
customer meets the suitability requirements for options trading.6 In particular, Rule
2860(b)(19)(B) requires that "no member or person associated with a member shall
recommend to a customer an opening transaction in any option contract unless the
person making the recommendation has a reasonable basis for believing, at the time
of making the recommendation, that the customer has such knowledge and experience
in financial matters that he may reasonably be expected to be capable of evaluating
the risks of the recommended transaction, and is financially able to bear the risks of
the recommended position in the option contract" (emphases added).

Members also should not make any generalized conclusions about the "relative"
suitability of a structured product and an investment in the reference asset. NASD does
not believe that members should assume that if an investment in the reference asset is
suitable, then an investment in a structured product pertaining to such reference asset
also must be suitable. Conversely, members should not assume that if an investment in
the structured product is suitable, then so too is an investment in the reference asset.
As discussed above, structured products may have very different risk-reward profiles
than their reference assets. Suitability must be determined on an investor-by-investor
basis, with reference to the specific facts and circumstances of each investor.

Moreover, where an instrument is structured such that there is a risk of losing all or
a substantial portion of the principal in return for above-market rate current income,
the volatility of the reference asset upon which total return of the investment depends
will be an important factor in determining whether it is suitable for a customer. For
example, structured product ABC with a highly volatile reference asset may pay an
interest rate of 40 percent to account for the risk, whereas structured product XYZ
with a less volatile reference asset may only pay an interest rate of 20 percent. Despite
the higher interest rate of structured product ABC, the risk of principal owing to the
increased volatility of the reference asset may make structured product ABC less
suitable for an investor than structured product XYZ notwithstanding its lower
interest rate.

4. Supervision and Supervisory Control System

Under Rule 3010, members must establish written supervisory procedures that are
reasonably designed to ensure that sales of structured products comply with all
applicable securities laws, and SEC and NASD rules. Members must ensure that their
written procedures for supervisory and compliance personnel include that (1) reasonable-basis
suitability is completed before products are offered for sale; (2) associated persons
perform appropriate customer-specific suitability analysis; (3) the firm has procedures to
determine accounts eligible to purchase structured products; and (4) all promotional
materials are accurate and balanced. In addition, members are reminded that their
written supervisory control system required under Rule 3012 requires members to test
and verify that their written supervisory procedures are reasonably designed to ensure
adequate compliance with all applicable securities laws, and SEC and NASD rules.

Firms also should consider the best practices for vetting new products discussed in
NTM05-26. These best practices include having compliance and legal personnel
involved in the initial product assessment and having supervisory personnel participate
in the product review process.

5. Training

Members must train registered personnel about the characteristics, risks, and rewards
of each structured product before they allow registered persons to sell that product to
investors. In connection with such training, members should train registered persons
about the factors that would make such products either suitable or unsuitable for
certain investors. Members' focus on training should not be limited to representatives
selling structured products; members also should provide appropriate training to
supervisors of registered persons selling structured products.

Training for all persons should emphasize that, due to the unique nature of these
products, many investors, especially retail investors, may not understand the features
of the product, and may not fully appreciate the associated risks of investing in them.
Moreover, in light of the fact that investors may be turning to these products as an
alternative to traditional equity and fixed income investments, it is crucial for registered
persons to have a full and balanced understanding regarding both the risks and the
rewards of these products.

1 There is no standardized definition of a
structured product in the federal securities laws.
SEC Rule 434 (Prospectus Delivery Requirements
in Firm Commitment Underwritten Offerings of
Securities for Cash) defines structured securities
as "securities whose cash flow characteristics
depend upon one or more indices or that have
embedded forwards or options or securities
where an investor's investment return and the
issuer's payment obligations are contingent on,
or highly sensitive to, changes in the value of
underlying assets, indices, interest rates or cash
flows." The Pacific Exchange defines structured
products as "products that are derived from
and/or based on a single security or securities, a
basket of stocks, an index, a commodity, debt
issuance and/or a foreign currency, among other
things" and would include "index and equity
linked notes, term notes and units generally
consisting of a contract to purchase equity
and/or debt securities at a specified time."
Securities Exchange Act Rel. No. 51094
(Jan. 28, 2005), 70 FR 6489 (Feb. 7, 2005)
(Order Approving Proposed Rule Change and
Amendment No. 1 and 2 Thereto by the Pacific
Exchange, Inc. and Notice of Filing and Order
Granting Accelerated Approval to Amendment
No. 3 Thereto Relating to a Proposed Listing
Fee Schedule for Structured Products). The
NYSE defines a structured product as "a security,
which is based on the value of another
security." Securities Exchange Act Rel. No. 42746
(May 2, 2000), 65 FR 30171 n.7 (May 10, 2000)
(Order Granting Approval to Proposed Rule
Change and Amendment No. 1 Thereto Relating
to the NYSE's Allocation Policy and Procedures).

3See, e.g., Department of Enforcement v.
Hornblower & Weeks, 2004 NASD Discip.
LEXIS 27 (respondent could not cure defects in
disclosure by providing more detail and further
disclosure in the same package or by answering
questions); DOE v. Ryan Mark Reynolds, 2001
NASD Discip LEXIS 17 ("The SEC has held that,
in the enforcement context, a registered
representative may be found in violation of
the NASD's rules and the federal securities laws
for failure to fully disclose risks to customers
even though such risks may have been discussed
in a prospectus delivered to customers.");
Department of Enforcement v. Pacific On-Line
Trading & Securities, 2002 NASD Discip. LEXIS 19
(finding that the subsequent dissemination of
disclosure information does not cure earlier
misleading disclosures).

Members also should consider whether their
disclosures concerning structured products
provide a basis for liability under sections
12(a)(2) and 17(a) of the Securities Act of 1933
(Securities Act) or section 10(b)(5) of the
Securities Exchange Act of 1934 (Exchange Act).
See In the Matter of Robert A. Foster, 51 SEC
1211 (1994) (notwithstanding distribution of the
prospectuses, party is liable under Section
10(b)(5) of the Exchange Act and Section 17(a)
of the Securities Act for making untrue
statements of material facts and omitting to
state material facts necessary in order to make
the statements made not misleading).

4 A nearly identical requirement also exists
with respect to listings of "Other Securities"
pursuant to Rule 4420(f). See Rule 4420(f)(3).

6 For structured products that are listed on an
exchange (or traded on NASDAQ), the
applicable listing standards typically require the
exchange (or NASDAQ) to issue an information
circular regarding compliance responsibilities,
including suitability and account approval). See
supra note 5. Member firms should review these
information circulars to ensure that they adhere
to the appropriate standards.